Last Friday, Congressional Republicans unveiled a tax plan that would make major changes to the U.S. taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. system. So far, much of the news coverage has focused on the plan’s promise to “dramatically simplify our broken tax code.” But how, exactly, would the plan go about doing this?
By my count, there are at least five major elements of the new House GOP tax plan that would significantly simplify the U.S. tax code:
1. The plan eliminates nearly all itemized deductionItemized deductions allow individuals to subtract designated expenses from their taxable income and can be claimed in lieu of the standard deduction. Itemized deductions include those for state and local taxes, charitable contributions, and mortgage interest. An estimated 13.7 percent of filers itemized in 2019, most being high-income taxpayers. s
The U.S. tax code allows taxpayers to claim dozens of itemized deductions. Thirty percent of American households choose to itemize deductions, and even more households keep the necessary records and perform the relevant calculations to determine whether they should itemize.
The House GOP tax plan would eliminate all itemized deductions besides the mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act reduced the amount of principal and limited the types of loans that qualify for the deduction. and the charitable contributions deduction, which would decrease compliance and recordkeeping burdens for households that itemize. In addition, it would significantly expand the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. , making it unnecessary for the vast majority of taxpayers to itemize their deductions in the first place.
2. The plan eliminates the alternative minimum tax
Every year, 4 million households are subject to the alternative minimum tax. These households – mostly from high-tax states, such as New Jersey and Connecticut – are required to calculate their tax liability twice: once under the normal tax system, and once under the parallel set of rules that apply to the AMT.
The AMT is one of the most complex portions of the individual tax code. One Forbes columnist calls it “the normal tax system’s evil twin,” while the Tax Policy Center has labeled it “the epitome of pointless complexity.” The House GOP tax plan would spare millions of households this compliance burden by completely eliminating the AMT.
3. The plan simplifies the treatment of capital gains and dividends
Under the current U.S. tax code, capital gains and dividends are taxed at lower rates than other types of income, in order to avoid the double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. of investments. However, it can be complicated for households to figure out what taxes they owe on their capital gains and dividends, due to a somewhat confusing calculation method.
The House GOP tax plan would replace the current treatment of capital gains and dividends with a simpler calculation method: a 50 percent exclusion. Households would sum up their capital gains and dividends and add exactly half of the total to their adjusted gross income. As a result, capital gains and dividends would be subject to exactly half the tax rate of all other income.
4. The plan reforms the treatment of foreign-source income
One of the most complicated areas of tax law is the treatment of income earned overseas. Currently, businesses are required to pay taxes on income they earn anywhere in the world, but are often allowed to defer their taxes on income from controlled foreign corporations, subject to a complex set of rules. One study from 1995 estimated that 40 percent of the tax compliance costs of large corporations is related to the taxation of foreign income.
The House GOP tax plan would move to a territorial tax systemA territorial tax system for corporations, as opposed to a worldwide tax system, excludes profits multinational companies earn in foreign countries from their domestic tax base. As part of the 2017 Tax Cuts and Jobs Act (TCJA), the United States shifted from worldwide taxation towards territorial taxation. , which would eliminate most of the complicated tax rules regarding overseas income. At the same time, it would make the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. border-adjustable, an elegant and simple way to discourage corporations from avoiding U.S. taxes by shifting their income overseas.
5. The plan moves to full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. of capital investments
Under the current U.S. tax code, when a business makes a capital investment (such as buying a piece of equipment or building a factory), it is required to deduct the costs of the investment over long periods of time, according to a set of more than a dozen depreciation schedules. The House GOP plan would eliminate the entire depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. system by allowing businesses to deduct the full cost of their capital investments immediately, a tax change known as full expensing.
The current system of depreciation is extremely complicated: every year, U.S. businesses spend 448 million hours complying with tax depreciation rules. By moving to full expensing, the House GOP tax plan would significantly simplify the business tax code.
All five of these features of the House GOP tax plan would make the U.S. tax code substantially simpler. However, the plan also contains at least one feature that would make the tax code more complicated: the 25 percent maximum tax rate on “small business income.”
Under the House GOP tax plan, individuals would be subject to a 33 percent top tax rate on most of their income, including wages and salaries. However, income that individuals earn from pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. es – such as partnerships, S corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s, or sole proprietorships – would be subject to a maximum tax rate of 25 percent.
The problem with this provision is almost immediately apparent. Imagine a lawyer who is subject to the top rate of 33 percent on his wages. Under the GOP tax plan, it would be advantageous for the lawyer to set up an S corporation, become an independent contractor, and recategorize his wages as “small business income,” which would be taxed at a 25 percent rate.
If the House GOP tax plan were passed in full, there would almost certainly be a scramble to recategorize wages as pass-through business income (and possibly a slew of new IRS regulations to curb this). As a result, the 25 percent maximum tax rate on pass-through businesses is one of the few features of the House GOP tax plan that would add complexity to the tax system, rather than simplifying it.Share